The new IS-LM: Summary

Three blocks The new IS curve The new Phillips curve The old LM curve

Properties of the model (I) Monetary shocks have an effect similar to the old ISLM model The equilibrium level of activity is inefficiently low because of imperfect competition The government is tempted to inflate to boost it closer to optimal level

The role of average inflation Erodes the markup (discount effect) Increases price dispersion The welfare maximizing level of inflation is slightly above zero

Inflation inertia The new Phillips curve exhibits no inflation inertia Consequently, inflation may be reduced permanently without an output loss That stands in contrast with models with past expected inflation

Impact of shocks The impact of a shock depends a lot on its expected duration: –Because of consumption smoothing –Because prices remain fixed for a while That can be seen by integrating IS and PC forward

Indeterminacy The model’s solution may be indeterminate if the monetary policy rule is not stabilizing enough Nominal interest rates must go up more than inflation so as to cool down the economy in response to inflationary bursts Otherwise, self-fulfilling booms and slumps may occur